In part 1, we mentioned that the implied vols are likely to come down if NSE implements the 1155 timeline for derivs trading. We explained that this is because the delta neutral option traders will make fewer and lower losses on hedging their option portfolios in the absence of many gap openings. In this post, we will see how exactly that works.
The only thing institutional option sellers fear is gap openings. They don’t care if the market moves continuously. This is because traders who sell options have delta neutral portfolios. That is, their option portfolios are not affected by changes in the underlying stock price.
When they sell calls, they buy enough futures (thanks Ratan Gupta for pointing the error I mad here) to neutralize the delta. When they sell puts, they sell enough futures to neutralize the delta. Note that institutions neutralize delta using futures and not stocks. So we will stick to futures for the rest of this article. Also, the word stock and future are used interchangeably since their price difference is negligible.
Delta measures how much the value of an options portfolio changes with changes in the underlying price. So one way to look at the delta of an options portfolio is the number of futures to buy or sell to keep the delta neutral. You might want to read the last sentence again.
Let’s explain that with an example.
Example 1 — You bought 20 BANK NIFTY at-the-money call options. The delta of this portfolio is +400 (work it out). This means you gain Rs. 400 for a Rupee upmove in BANK NIFTY. If you have a sell position of 400 futures or 10 lot futures, you will lose 400 Rupees for a Rupee upmove. Put them both together, (options + 10 lot futures sell), and now you have +400 + (-400) = 0 — a Delta Neutral Portfolio! So this +400 which is your gain per Rupee upmove is also the number of stocks or futures you have to sell to maintain Delta at 0.
Here comes the problem. Delta is not a constant. It increases and decreases with the stock price. The more the move in the stock, the higher the change in delta. So if you have an options portfolio which is delta neutral now, it might not be delta neutral after the market moves. So you have to buy or sell futures to bring it back to neutrality. The higher the move, the more is the number of futures you have to buy or sell.
Now comes the nasty problem. To neutralize delta of an options portfolio where you sold options, you have to buy futures when the market goes up, and sell futures when the market goes down. And you have to buy a lot of futures when the market goes up a lot, and sell a lot of futures when the market goes down a lot.
Yes, buy high sell low. And buy many more at higher levels, and sell many more at lower levels.
This sounds like a trader’s nightmare. It is. And that is what happens during gaps.
Example 2 — NIFTY is at 10500. I have a delta neutral NIFTY option portfolio, in which I have sold options to begin with. That is, I have sold several call options and I have half the number futures bought against them to make delta 0. If NIFTY moves down 100 points, my delta changes and becomes 750, and I have to sell 10 lots of futures to neutralize this. I will sell 10 futures at a price of 10400 if there is a hundred point gap down. If it goes there continuously, I will sell 1 lot each at every 10 points down, which means an average price of 10450. It is better to sell at 10450 than at 10400, right?
Now NIFTY is at 10400. Next, let’s imagine the market moves back to 10500. My delta will be -750. I have to buy 10 lots at 10500 if it is a gap up of 100 points. But I can buy 1 lot every ten points if it is continuous. Which gives me an average price of 10450.
So I sold and bought 10 futures at an average price of 10450 with continuous delta hedging (not technically, there is a small difference between buy and sell price, figure that 🙂 )
But with a gap down and gap up, I sold 10 lots futures at 10400 and bought 10 lots at 10500, which gives me 75*10*(10400–10500)= 75,000 Loss on delta hedging. Note that my sell options portfolio remains the same. I will make some money on that due to time value decay if all these moves happened in some 3–5 days, especially near the expiry when Theta is the highest.
Now you know why traders with delta-neutral portfolios hate gaps. You also know if there are no gaps, they will not make many big losses. This means lower risks, and they will be willing to sell options for a cheaper premium and lower IV.
All this works in theory. Let’s see what comes of the SEBI move, right? Because all said and done the exchanges still can decide not to do the 11:55, though the chances of that look low.